Annuity Purchase Advice
There are two kinds of annuities: Deferred and immediate. Deferred annuities are purchased with earned income and have an accumulation phase that can last for several years, and in some cases, decades. The money used to make the purchase can either be qualified, meaning that it has not yet been taxed, or non-qualified, meaning that taxes have already been paid on it. Money is contributed monthly, quarterly or annually and the earnings and interest credited to the account grow tax-deferred until the annuity owner begins to receive payouts during the distribution phase.
How Annuities Are Funded
Immediate annuities are usually purchased with non-qualified money and do not have an accumulation phase. They are funded with one lump-sum payment. The money used to make the annuity purchase can range from an inheritance to the proceeds from the sale of property. Distribution begins immediately, usually within one to 12 months of the annuity purchase. The earnings and interest credited to an immediate annuity also grow-tax deferred, just as they do with a deferred annuity.
Annuities can earn a fixed rate, an indexed rate or a variable rate. While the fixed rate option is not usually recommended for a deferred annuity purchase, it can be considered if the annuitant is close to retirement. An index annuity purchase earns a return that is tied to the increase of a stock market index. The most commonly used index is the S&P 500 as it represents a diverse number of companies and industries. A variable annuity earns a rate of return based on investments that are made with the money contributed by the annuitant. He or she can usually choose among ultra-aggressive and ultra-conservative funds, and every type in between. Investors are advised to fully understand that a loss in the underlying investments will result in a loss of principal.
Why Purchase an Annuity
An annuity purchase can provide an excellent way to save additional money for retirement. Because they grow tax-deferred, more money remains within the account to compound over a long period of time.
An annuity can also guarantee income for life, which is quite beneficial to those workers who do not have an employer-sponsored pension. By purchasing an immediate annuity, the annuitant guarantees that he or she will receive a monthly payout either for life or for a set number of years. The length of the payments is written into the contract and cannot be changed once payments begin.
Annuities are sometimes purchased as an alternative to whole life insurance. Both enjoy favorable tax status and provide the possibility of long-term financial gain and security. While the benefit of a whole life policy would be the death benefit, an annuity purchase can at least include a guarantee that any money not returned to the annuitant in the form of monthly payouts would be returned to a beneficiary.
In other words, if an annuitant purchases a $250,000 immediate fixed annuity and only has $65,000 returned in the form of the payouts, the beneficiary will receive the balance of $185,000. The type and cost of any guarantee depends on the insurance company that writes the contract, but most will provide some form of assurance that the entire amount of the contract will not be lost if the annuitant dies early. Annuities can also be purchased with a Cost of Living Adjustment (COLA) rider that ensures the amount of the payouts increases in order to offset the effects of inflation.
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What is the Best Way to Make an Annuity Purchase
When considering an annuity purchase, investors are first advised to determine which type of annuity, deferred or immediate, they need. The next step is to choose how much risk they are willing to take to obtain returns. For those who are risk averse or very near to retirement, a fixed annuity is usually the best choice. For those with a longer time horizon or those who are able to take higher risks in order to earn higher returns, a variable annuity might be the best fit.
It’s also important to make sure that the insurance company from which the annuity purchase is being made has been rated highly by the four credit rating agencies. A.M. Best, Fitch, Moody’s Investor Services and Standard & Poor’s all rate the creditworthiness of insurance companies. The ratings reflect the ability the insurance company has of meeting its financial obligations in the form of the annuity and life insurance policies it has sold. Both annuities and life insurance contracts represent debt that will mature sometime in the future.
It’s important to know that the insurance company has been managing its credit properly. Further, if making a variable annuity purchase through an independent life insurance agent, it’s important to make sure that he or sure is registered with the Securities and Exchange Commission and is licensed by the National Association of Securities Dealers as he or she will be recommending securities.
The Right Annuity Purchase for a Retiree
The right annuity for a retiree is almost always an immediate fixed annuity. One major advantage of this type of annuity is that the payout remains the same, regardless of the ups and downs of the stock market. Even if the major stock indices like the Dow Jones Industrial Average and the S&P plummet, the annuitant is guaranteed to receive the payout stated in the contract. And, if he or she chooses to receive payments for life, there is no risk of outliving his or her savings.
Given a low interest rate environment, it’s also possible that over the duration of the annuity contract, the amount of interest paid at the fixed rate will be higher than that paid on savings accounts or Certificates of Deposit. An immediate fixed annuity could also be considered if the retiree is currently taking distributions from a qualified retirement savings plan such as a 401(k) or SEP IRA. If he or she does not need the distributions in order to meet monthly expenses, he or she could see a greater rate of return than by simply purchasing CDs.
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